Negative production externality occurs when producing a good causes a harmful effect to a third party.

In the case of a polluting chemical factory, the managers take into account only their private costs of raw materials and running the plant. But because nobody owns the atmosphere and firms don’t have to pay to pollute it, no mechanism is in place for making the plant’s managers take into account the costs of pollution that fall onto members of the broader community.

Diagram explained

The private marginal cost and The social marginal cost

The firm’s supply curve (S1) is its private marginal cost curve (MPC), which takes into account only the firm’s own costs of producing chemicals.

The supply curve S2 is also the MSC (marginal social cost) curve. It takes into account not only the chemical firm’s private marginal costs (MPC) but also the external pollution costs (MEC) that is, the negative production externalities. The MEC is the vertical distance between the MSC curve and the MPC curve.

The private marginal benefit and The social marginal benefit

We assume that the chemical factory generates no positive externalities, thus the marginal private benefit (MPB) and the marginal social benefit (MSB) are the same.

Market equilibrium vs Social optimum amount

The market equilibrium is where the private marginal benefit curve (MPB), crosses the marginal private cost (MPC) curve. That equilibrium results in a quantity Q1 of chemicals being produced.

On the other hand, the socially optimal amount of chemicals to produce is Q2. The point where the social marginal cost curve (MSC) crosses the social marginal benefit curve (MSB) determines the socially optimal quantity (Q2).

There is an overproduction of chemicals from Q1 to Q2. The market fails because the chemical factory produces too much chemicals. At the free market price of P1, chemicals are too cheap. The price would have to rise to P2 to bring about the socially optimum level of consumption.



Regulations

Governments frequently use regulations to overcome market failures caused by production externalities. The government might intervene by setting standards that restrict the amount of pollution that can be legally dumped by a firm.

Laws

The government may pass laws that directly target the negative externality itself (rather than the underlying activity that leads to the externality). For example, by setting standards that restrict the amount of pollution that can be legally dumped by a factory.

Pollution permits.

Unlike indirect taxation and regulations, pollution permits are a free market solution as they can be bought and sold. Polluting firms are given a certain number of ‘permits to pollute’ over a given time period. If a firm emits a lower level of pollution, it can sell its spare permits in the market to firms needing to buy more permits since they have used up those allocated to them.

Taxes

The government impose an indirect tax, which is ideally equal to the marginal external cost (MEC). This tax is added to the cost of producing the product; the supply curve S2 is now equal to the MPC plus this tax. The price would rises to P2 and quantity falls to Q2 bringing about the socially optimum level of consumption. The effect of the negative externality is now internalised within the market.